From the comments, on downturns, fiscal policy, and multiple equilibria

Call me an AD-denier, but I still think the basic issue here is that you can’t consume more than you produce. Production exists to satisfy demand, but at the same time demand is limited by production. We had a long boom built on the notion we could boost demand and thus supply and thus demand again in a virtuous cycle, and now we are seeing the cycle work in reverse as demand/supply seek their natural levels.

One way to justify this model is in terms of multiple equilibria, and that we have been walking (bouncing our heads?) back down the escalator. Arguably for the United States this downward bouncing is over. Along the way we are sending signals about the quality of our institutions and thus shaping the course of the future.

In this model there is still a useful role for fiscal policy. For one thing, fiscal policy can smooth that ride down the escalator, by spreading the losses out over time, at the cost of future debt of course. This may be needed if only to make the political economy of decline less bitter; see Spain and Greece. Nonetheless fiscal policy cannot make up for the output losses at will. We are not standing in an IS-LM diagram where the difference between “what we have” and “what we could have” is thwarted only by some supposed Austerians who won’t shift the proper curve and yet somehow have taken over some of the biggest spending social democratic, insider-leaning governments in world history. The IS-LM approach fits in nicely with the view that policy improvement is all about yakking about the obstructionists. Instead, policy is also about rebuilding trust, not just maintaining ngdp on a decent keel.

There is another possible role for fiscal policy, as there usually is in models of multiple equilibria. If you ran some super-duper fiscal policy, and invented the flying car, a cure for cancer, and other marvels, the market might suddenly latch its expectations on to a much more positive scenario. There could be a significant upward bounce to a much higher equilibrium of output and employment. In any case, the quality of fiscal policy matters, and Keynesian ditch digging probably doesn’t do much for inferences about institutional quality and for the selection of multiple equilibria. “Spend the money, anywhere” is in my view a deeply pernicious attitude, somewhat akin to thinking you can create a good NBA team, with a strong ethic for quality and work, by tanking for better draft picks at the end of every season. But no, the internal ethic matters and cannot be first destroyed and then recreated at will. Good teams don’t usually work that way, and neither do good fiscal policies.

Right now we Americans are building back up to better equilibria, slowly, by showing that our economic institutions are not totally crummy. This process can take a good while, but in fact our recovery is going better than many people believe. The eurozone is far — very far — from being on that kind of rebuilding track.

There is plenty of talk about various commentators don’t understand the lessons of Econ 101. There is a reason why we teach classes beyond 101, and why we spend so much time studying institutions and the theory and empirics of public choice.

Tyler: “In this model there is still a useful role for fiscal policy. For one thing, fiscal policy can smooth that ride down the escalator, by spreading the losses out over time, at the cost of future debt of course. This may be needed if only to make the political economy of decline less bitter; see Spain and Greece.”

Doesn’t this mean that you essentially agree that near term policy should be some degree of further stimulus, as long as it’s tied to medium-to-long-term deficit reduction (*deficit* reduction, which could mean a combination of tax increases and spending reductions)? The debate then becomes about what kinds and amount of stimulus to pass to help the political situation going forward for substantial longer term reform.

This is the major problem — we’re already spending way, way more than we can afford, the recession ended almost three years ago, and yet people (lots of people, not just you Tom) are saying “Well, now looks like a time when we need further stimulus.” I really worry that we’ve painted ourselves into a corner by sacrificing long-term economic growth for short-term fiscal stimulus to the point where we can no longer have a strong recovery.

What makes you think there was going to be a strong recovery to begin with?

If we didn’t have an Energy Department or Nuclear Regulatory Comission we could build out 1 GW nuclear plants as far as the eye can see. Without a Federal Aviation Administration, maybe we could develop new forms of air transport to replace rickety 60’s vintage planes. In the absence of the EPA, perhaps the West could be developed as well as the East was prior to the emergence of the regulatory state. As it is, Keynesian policies vs. Austerian/Austrian will amount to very little indeed.

SteveApril 29, 2012 at 1:00 pm

“the basic issue here is that you can’t consume more than you produce. Production exists to satisfy demand, but at the same time demand is limited by production.”

I see this statement often and each time wonder how it is relevant to current conditions. When millions are sitting unemployed it is clear production is not at its limit. Can someone explain this?

derekApril 29, 2012 at 4:42 pm

Production is happening elsewhere. Unfortunately those unemployed workers either don’t have the ability to produce what the market wants or cannot at the price the market is willing to pay.

Borrowing money to employ these folks only raises the cost of their labor when it comes to the competitive market.

SteveApril 30, 2012 at 12:57 am

Thanks for the attempt to answer the question but still must say I do not understand how demand is limited by production.

Doc MerlinApril 30, 2012 at 2:23 am

@Steve

“Thanks for the attempt to answer the question but still must say I do not understand how demand is limited by production.”

Because in order to consume, someone must have produced the good. You can consume more than you produce either by stealing, enslaving, fraud, charity, or some form of transfer payment. But /everyone/ can’t produce more than is consumed, its at best zero sum. Also, for short periods of time, one can consume more than one produces by selling promises of future production (debt).

Does that help any? One thing that helps is to realize that money is not wealth, its just a medium of exchange to help us do accounting.

SeshApril 30, 2012 at 12:54 pm

But that still doesn’t answer the question: when so much productive capacity is lying unused, how can the argument that demand is being limited by production be made?

Yancey WardApril 30, 2012 at 2:31 pm

But that still doesn’t answer the question: when so much productive capacity is lying unused, how can the argument that demand is being limited by production be made?

It is lying unused because it wasn’t producing anything that had a sustainable demand. Take housing for example- when it became clear that the debts incurred to buy a house were not sustainable/payable, the market collapsed, taking away the employment opportunities of builders, real estate agents, and those involved in mortgage finance. These resources will continue to lay unused until the market figures out something else to produce with them that has a sustainable value for exchange. Every program the government implements to try to use these resources just puts off that day in which that new sustainable employment is identified. Seriously, the government could put these people to work tomorrow digging ditches and refilling them (or even just giving them income transfers), but it won’t increase production in the long run because you still need to produce something to exchange for something else. Getting printed/borrowed dollars from the government doesn’t actually count as production.

JWattsApril 30, 2012 at 3:29 pm

“But that still doesn’t answer the question: when so much productive capacity is lying unused, how can the argument that demand is being limited by production be made?”

Because Labor isn’t very fungible in modern America. For example: Consider the case of a demand for nurses (production limited nursing) and a surplus of Laid of construction workers. In simplified theory all of the construction workers could readily be converted to nurses.
But in the real world, out of the vast amount of surplus construction workers, only a certain fraction have the ability to be nurses (assuming modern nursing certification requirements), out of that fraction, only another smaller fraction has the desire to be a nurse and out of that remaining fraction most will need to be re-trained and this same sub-group will have multiple options, so only a few will actually ever be re-trained and become nurses.

SteveApril 30, 2012 at 9:10 pm

@Doc thanks that does help!

SteveApril 30, 2012 at 9:50 pm

@Yancey

“Every program the government implements to try to use these resources just puts off that day in which that new sustainable employment is identified.”

Very good response. Above is the only part I am not 100% on board with. Some could say government stimulus is filling the gap while the market adjusts.

mpowellMay 1, 2012 at 1:45 pm

Also, for short periods of time, one can consume more than one produces by selling promises of future production (debt).

But you can’t do this collectively. Seriously, this whole argument assumes it’s conclusion as it’s premise. The construction sector in the US is a small fraction of those unemployed. Demand theories of economic contraction were developed to explain such oddities. The alternative of just insisting that whatever unemployment existed reflected real limits on production at a supportable price isn’t very compelling. If you want to advance this theory, how about some actual evidence for it?

M.R. OrlowskiApril 30, 2012 at 2:09 pm

I think that he is referring to Say’s Law of Markets.

CBBBApril 29, 2012 at 1:02 pm

Right now we Americans are building back up to better equilibria, slowly

I see no evidence of this. And slowly isn’t good enough – how many people must essentially forfeit their lives in this wild goosechase?

Andrew'April 30, 2012 at 7:58 am

Do you even understand that you are building in a huge unproven assumption?

“policy is also about rebuilding trust” – you might enjoy this article at The Browser, “The Trust Molecule” by Paul J. Zak.

Larry RothfieldApril 29, 2012 at 5:24 pm

So ditch-diggers do not display a work ethic?

Benny LavaApril 29, 2012 at 7:20 pm

There are a great many economists who don’t really understand econ 101 – or econ 401 for that matter! – which is why I am dismissive of these sorts of ad hominems. We need to see the evidence clearly for what it is in order to reach a greater understanding, not to simply reinforce our own false notions.

“demand is limited by production”

Doesn’t this really beg the question: “what is demand and how does one measure it”? Something economists have long struggled to even think about. How do you measure latent demand? It is clear that consumers want products that haven’t reached the market yet, such as teleportation devices. How can you possibly measure demand for that?

Production is many things. Quantity, quality, price, etc. So then we should also define our terms and ask: “What aspect of production is limited?” Just one? All of them?

Economists be bold! Dare to think for once. Don’t be imprisoned by peasant doctrines!

IMO, the model described by Tall Dave/ Tyler has a serious issue, even if I might agree on the limits and use of fiscal policy.

It doesn’t explain anything! Why does Demand vary? Why does Production (supply, surely?)? We haven’t lost any technical know-how, factories weren’t burned, input prices have not been particularly helpful but are not trading outside of the norm and, tsunami asides, we haven’t had major catastrophes wiping out production… So…

Andrew'April 30, 2012 at 8:00 am

Christ people. Houses?

Yes, we can keep building houses like gangbusters. I almost think we should. But that doesn’t mean it wouldn’t be a disaster.

The Keynesians keep saying “Hey, you proved you could produce X GDP, it matters not what that is composed of disaggregated, keep producing X GDP!”

Replace houses with widgets and never adjust to overcapacity!!! Deflation be damned! We’ll just print money!!!

You said the C, I, and G aren’t perfectly fungible. I’m not sure I agree. It’s not necessary for capital goods to be worthy or consumption or government purchases to be equivalent to consumer expenditures. All that is necessary is that the RESOURCES used to contribute to C, I, G, and NX are more or less fungible. Steel, for example, can be used for a car, a combine, a tank, or an airplane. A carpenter can ply his trade in any of these components of GDP.

The overhang of houses has idled some resources for housing that perhaps cannot be quickly absorbed by components other than C, even with price drops. I assume that’s the line you were headed down. To some extent It’s true. As you say later, It’s more true NOW because of massive malinvestment in housing. Illegal aliens made up a substantial share of construction labor, and they took it on the chin. Them dropping out of the labor force accounts for some of the fall in the unemployment rate.

A bigger problem may be the disintegration of structured finance. We’ve lost valuable tools for financial stabilization because they were misused and nobody trusts them anymore. Im having a very hard time finding hedges for substantial risk exposures that clients are willing to accept. More and more investment policy statements are imposing unrealistic and self-defeating constraints. I am hesitant to even bring it up, lest I frighten people away.

What is overcapacity when you (or rather Tall Dave but he seems to agree with you) says production limits demand. How can you have overcapacity in that world?

Obviously, you can have overcapacity in my world – when demand deflates compared to past levels. Why does that happen? Not really anything to do with prices per se, although, of course, that will play a role in ‘normal’ times. But, right now, demand is depressed because people lack purchasing power and either the confidence or the capacity to use (further?) debt to support consumption.

It really isn’t more complicated than that. Or so it seems to me. IMHO, fiscal stimulus is a poor substitute to making sure individuals recover the ability to spend – either via increased real income/real wages or via debt reduction/renegotiation/forgiveness/combination thereof.

Once people can spend again (in a sustainable fashion, this time, if possible!) – all will be well…

Well, there is always overcapacity somewhere, this is communicated is by prices. Too much capacity for producing corn? Corn prices fall, corn farmland is idled or put other uses (soybeans, wheat, etc) in response. There is no “right” level of corn production, but prices will tell producers what to do.

The problem was the overbuilding of housing on the back of an unsustainable debt bubble. That bubble has now popped, and so there is an excess of housing, and the excess building capacity has been idled. Meanwhile, a horrifying amount of homeowner wealth (built on misallocation) has evaporated like the dew.

I think the issue is not that it doesn’t explain anything, but rather that it doesn’t give policymakers easy answers as to what to do. Essentially, the answer in this model is “you’re paying the price for a gigantic misallocation of productive capacity; just suffer through it until markets clear the problem, and for God’s sake never do another housing bubble!”

Demand recovers when production is again better matched to what consumers want, to the point that the fruits of that production drive more demand. Unfortunately, we’re seeing that cycle work in reverse while the damage clears.

Benny LavaApril 30, 2012 at 7:13 pm

What is the difference between a demand shortage and a production shortage? I mean the way production is described herein it is identical to deman shortfalls. I see no real difference. And why would there be as they are two parts of the same demand-supply equilibrium.

Now if we were talking about the spike in commodities or gas prices that would be different, and we would be having a different discussion.

In terms of policy the difference is important — the government is not very good at producing more of the non-public goods people want, but it does have a knack for handing out money!

So the problem arises when you ask whether what we really need is more (properly allocated) production or more demand. The first is very hard to do (start a business if you don’t think so!), especially for policymakers, but under this model it is the more correct answer.

Curious BystanderApril 30, 2012 at 9:00 am

>> Why does Demand vary?

Prices. More precisely, relative prices. In 2009 America had the technology and resources needed to produces (roughly) the same amount of housing as in 2007. Period.

Except that, the same housing production in 2009 would have generated a lot less demand in other sectors of economy than it did in 2007.

WillittsMay 1, 2012 at 11:28 am

There are a great many economists who don’t really understand econ 101…Doesn’t this really beg the question: “what is demand and how does one measure it”?

There are a great many commenters who don’t really understand Philosophy 101.

consumers want products that haven’t reached the market yet, such as teleportation devices

Latent demand (induced demand) is often measured by firms engaged in R&D, investment banks, and transportation planners. In finance, we measure mispricing of IPOs by one-day returns or subscription levels, but even there the underpricing appears to have a rational basis that goes into the decision making process a priori. The objective function isn’t what you think it was.

Markets may not price “pie in the sky” developments, but they make a decent attempt to price imminent supply. Consider that economic consumers apply a probability distribution to the presentation of new products. If I have good reason to suspect that the iPad 4 will come out this Fall with better features, I might defer a purchase of an iPad 3. However, if I apply a near-zero probability of a superior platform being introduced during the useful life of existing products, I won’t defer a purchase decision.

I agree that what economists purport to measure is overly broad and poorly defined; however, you run the risk of measuring the beach by counting grains of sand, or worse, with an ever-decreasing ruler.

To me, macroeconomics is practically voodoo. The decisions of billions of economic actors making quadrillions of transactions based on thousands of variables, some of which defy measurement or rationality, cannot be reliably predicted. It’s difficult to measure, without argument or ambiguity, the effects of the fiscal stimulus ex post much less craft an effective policy for what ails us now.

Assumptions of homogeneity simplify otherwise intractable models. Much research seeks to resolve apparent deviations from homogeneity and relax strong assumptions. You might get misleading results from a simplified model, but you get no results from one that cannot be solved.

WillittsMay 1, 2012 at 11:29 am

Ack! Some commenters don’t know how to use closing tags in hypertext. Sorry.

Good points on fiscal policy — I would hold up X Prizes as a great advance in public spending that should be utilized more, especially as stimulus, but unfortunately the tendency is more to buy a bunch of cars and never drive them. If only everyone agreed G was not truly fungible with I and C, we could grow gov’t in bad times and shrink it in good/okay times, and all would be well.

I think the point about America building back up to better equilibria is a great one, and I credit American sociocultural captal, still our greatest asset imho. Here we do not burn down banks with pregnant women inside when the gov’t cuts spending, Communism never gained a foothold, our medical system still has a soupcon of free markets, etc. OTOH, I believe a large G erodes the internal ethic you refer to, in much the same way that free markets encourage them. Incentives matter!

So I do worry that with gov’t at 40%, debt at 100%, and deficits at 5-10% of GDP, we are striding confidently up to the edge of the cliff Greece is falling off of right now — they’ve run up against hard limts to fiscal policy (i.e., insolvency and the inability to borrow) and now as they’re forced to cut they find the unwinding is happening faster than they cut, and reaching a new equibrium seems increasingly difficult. What happens to the U.S. if short-term rates spike and we end up walking the Plank curve? The seemingly prevalent atitude of “that’s never going to happen” is the opposite of comforting, it reminds me too much of the people who kept borrowing equity against their homes’ value because everyone knows home prices will always go up…

Benny LavaApril 29, 2012 at 9:19 pm

I have big problems with people who compare the US to Greece, which does not even have its own currency, instead of the most obvious analogue which is Japan. Usually it is because Japan suffered from deflation and the doomsday crowd usual crows about inflation (often of the hyper variety). Our own Tyler Cowen is guilty of this.

Be careful with letting your emotions cloud the data!

claytonApril 30, 2012 at 1:47 am

I have big problems with people who compare Japan to the US. Is experiencing a prolonged period (nearly decades?) of deflation that comparable to the 9 months the US has? Not to mention there are vast differences in demographics, their demographics trends, and the composition of economies.

Benny LavaApril 30, 2012 at 8:43 am

Surely even you can see that America is more similar to Japan than Greece. Population, GDP, per capita GDP, sovereign currency…in just about every way America has more in common with Japan than Greece. Not to mention both nations experiences a housing bubble followed by stagnation and deflation. I mean seriously are you a Tall Dave sock puppet? Because otherwise your post is laughable!

claytonApril 30, 2012 at 7:46 pm

So since Japan is more similar to the US than Greece, Japan has to be similar to the US! Got it. I note that you didn’t disagree with a word I said. Go to bed Benny, it’s time to let the grownups talk.

It costs Japan half of the country’s tax income just to service its debt….Conventional wisdom is that Japan is safe as long as it keeps covering about 95 percent of its borrowing needs at home. What emerges from a dozen or so interviews with fund managers and officials versed in monetary and fiscal policy is that a risk of domestic investors going on a strike is what makes them particularly nervous…Budget arithmetic and demographics suggest that it will take another decade before Japan’s swelling ranks of retirees will begin to run down their vast savings to the point where Tokyo will need to start borrowing more from overseas lenders…Even tax hikes on such a scale will fail to reduce the debt burden if Japan remains stuck in deflation and anemic growth, he warns. “If we stay in this situation, this amount is never repayable. It’s just impossible.”

Matthew C.April 29, 2012 at 11:20 pm

The “quality of our institutions”? Like claiming a GDP deflator of 1.1% when the real inflation rate is closer to 11%? Is more brazen lying really a sign of quality?

Doc MerlinApril 30, 2012 at 2:11 am

“For one thing, fiscal policy can smooth that ride down the escalator, by spreading the losses out over time, at the cost of future debt of course. ”

I really don’t see this as useful, as don’t have a problem of short term losses but of long term debt.

WillittsMay 1, 2012 at 11:36 am

The problem is when you don’t know how long and bumpy that escalator ride is.

A bigger problem is when you try to smooth out the ride, the bumpy ride gets longer.

Another problem is when you try to smooth out the ride, the ride develops problems other than bumps.

A different but coexisting problem is when you smooth out the ride for some at the expense of others.

Finally, the biggest problem is using the metaphor of a bumpy road for an economy.

bxgApril 30, 2012 at 2:20 am

> The “quality of our institutions”? Like claiming a GDP deflator of 1.1% when the real inflation rate is closer to 11%? Is more brazen lying really a sign of quality?

Why stop at this? So long as you are saying that official statistics are off by 10x, but apparently that’s so obvious it doesn’t need a citation or evidence or anything, why not just do a thin-airing of an even more impressive number? Maybe 110%? 1100% 11000%? There’s no real limit to the evil of this Obama character, right, so why be so restrained?

Could you please cite your source? And maybe, just to show it isn’t patently ridiculous, after you cite the source could you tell us what that same source’s figures imply for the real inflation rate over the last decade? (For example: if your sources figures say we are 1/4 as poor as we were in 2002 – that would be a sanity check fail.)
If it helps you may assume that our lives consumption: housing, food, education, & etc, is not solely comprised of 100% gold.

Doc MerlinApril 30, 2012 at 2:44 am

Assume a world with No increases in money supply or increases in population.

Now CPI would be normally falling, because productivity increases make products cheaper. Now, allow money supply to increase… and you get inflation, but CPI is still negative until money expansion is higher than productivity increases.
Anyway the point of this is that to see the actual effect of inflation, one needs to add price level changes and productivity growth rate. While this shouldn’t be 10%. Its never the less, much higher than the ~4% CPI inflation rate.

BillApril 30, 2012 at 7:45 am

This falls into the category of “What do you believe you know is not true.”

WillApril 30, 2012 at 6:33 am

Quite a few sources for this, actually. What it really comes down to is arguing over what components should be included in core/headline cpi, etc. Also hedonic adjustments (The government says we’re better off because youtube has enhanced the value of internet to us).

It’s inherently a flawed measurement because people buy different things. If you are a person that is accurately profiled by the CPI index, then it is a good measure of price level for you. If all you want to buy is gold and oil, well then tough.

Yes, I’m also increasingly of the opinion that inflation is another issue that tends to validate the Austrian criticism of econometrics as often failing to tell the whole story.

WillittsMay 1, 2012 at 11:41 am

Never forget that these “measures” were developed with specific models and specific socio-economic goals in mind.

For example, the official unemployment rate measures the type of unemployment that fiscal policy is supposed to be able to ameliorate and not unemployment that it cannot ameliorate. The measure isn’t flawed – the model is flawed and the goals are value-laden.

Andrew'April 30, 2012 at 7:56 am

Yes, and rarely does anyone talk about, except to snicker at PK who now denies it, but the housing bubble WAS an attempt to boost demand.

JasonApril 30, 2012 at 11:09 am

“There is plenty of talk about various commentators don’t understand the lessons of Econ 101. There is a reason why we teach classes beyond 101, and why we spend so much time studying institutions and the theory and empirics of public choice.”

If the size of effects you describe in Economics 614 are comparable the size of effects in Economics 101, then there is something seriously wrong with the discipline. Economics 101 should follow an 80/20 rule … and I’m not sure prediction in economics is 20% accurate!

Physics 101 delves into Newton’s laws, which govern the vast majority of human experience. Quantum mechanics, relativity, solid state physics, etc. all represent details. Chemistry 101 is thermodynamics. Biology 101 is cells. Even the majority of math everyone uses today they learned in their first math classes in Kindergarten.

I point this out: NGDP (or even RGDP) vs time is a straight line in log space to very good accuracy. Therefore NGDP targeting (monetary policy aims for that line) or [New] Keynesian stimulus (monetary interest rate target plus adding government debt to eliminate the output gap from that line) are the only things that can happen.

I guess there is the Austrian version, which is do nothing … but I’m not sure what “doing nothing” is in monetary policy. I guess it’s a 2% inflation target.

One possible interpretation that makes sense of the quote above, that Economics 614 is as important as Economics 101, is that the (Economics 101) policy prescription advocated here is, to first order, *do nothing*. Only in that case do the small effects of Economics 614 become the primary policy prescriptions.

I have a hard time believing that fiscal policy “smooths out” anything because one of the first things my professors taught me in undergrad was that the exact opposite is true: fiscal policy makes things worse.

WillittsMay 1, 2012 at 11:50 am

What your professor probably taught you is that if fiscal policy is poorly timed, it can make things worse.

Long and variable lags between identifying an economic problem, producing policy, and having the policy take effect may exacerbate rather than smooth business cycles.

One issue is whether the model of business cycles is correct. Another is whether the policy prescriptions would work as intended when optimally timed. A third is whether we can optimally time policy prescriptions.

This all has to be weighed against the cost of doing nothing – both economic and political costs. Herbert Hoover lost and FDR won because there was a public perception that he didn’t do “something” enough. Unfortunately, we can’t divorce the public choice aspects from economic policy aspects. Even dictators are removed during economic crises, e.g. Mubarak.

If you’re not going to explain what you were taught (why you believe it is another matter), then it’s rather hard to respond to your comment.

You see, several generations of Econ students were taught that fiscal policy DOES smooth out business cycles, especially through so-called automatic stabilizers.

I don’t believe them any more than you do. They at least try to explain what they believe and why, and then we can criticize the what and the why.

You’re not giving us anything to agree or disagree with. You’re only regurgitating what one economist told you. I wouldn’t buy that even if I agree with it.

So, why would fiscal policy make things worse? What did your professor tell you that impressed you so much? I can pretty much rule out that he was a Keynesian or a Classical economist. The former believes it works and the latter says it is ineffective (neither better nor worse). I think Marxists would have similar policy prescriptions to Keynesians. I assumed therefore he was a monetarist, but perhaps he’s an Austrian.

I do not really get how we could have consumed more that we produced unless we did it by borrowing from outside the USA or by consuming capital. Together they do seem big enough.

WillittsMay 1, 2012 at 12:16 pm

You are correct about trade. We can consume more than we produce through trade, even without debt. We can consume more than we produce through debt too, at least temporarily and perhaps perpetually if all the stars align.

I don’t follow what you mean by “consuming capital.” You can’t eat a combine. If you eat dough, tomatoes, and cheese, you are substituting dough, tomatoes, and cheese for consuming pizza.

I believe TallDave was referring to Say’s Law or the GDP identity. To me, Say’s Law makes sense but it’s not falsifiable. The GDP identity includes C, I, G, and NX. Resources are assumed to be fungible between the components of GDP.

If by “consuming capital” you mean allocating fewer resources to capital replacement in order to sustain current consumption, then that may have an impact on economic growth if the choice is between building a car and building a machine that builds cars. In an expected short-lived recession, consuming rather than investing might be desirable. You’re borrowing from your own future consumption.

The investment conundrum is thus: interest rates are incredibly low, so businesses have substantial incentive to invest – low interest rates alter the cost-benefit analysis of investment decisions. However, the decision to invest depends on expectations of future demand. Low interest rates affect costs, expected demand affects benefits – therefore the effect on cost-benefit analysis is ambiguous. This is the essence of the Paradox of Thrift.

I tend to doubt the Paradox of Thrift. I have yet to see empirical evidence for its existence. It may be a tempest in a teapot. Manufacturing in the US is doing quite well; many business are investing in farm equipment, computers and electronics, cars, etc. Low interest rates are driving purchases of long-lived assets (except housing which still has overhang). The problem is that this isn’t a sustainable source of growth. By definition, the purchase of long-lived assets undercuts future demand. Technological leaps must be enormous to provoke retiring long-lived assets before the end of their useful lives.

My point was more that we can’t consume more than we produce right now. And we can’t produce all the housing we used to, because no one wants it. So, we’re going to have some pain until those idled resources figure out how to provide stuff people do want.

Sadly, we borrowed more and spent saved capital. This looked like a good deal as long as home prices rose — bubbles usually do — but in end a lot of that fake wealth evaporated like the dew and we were left with today’s situation.

WillittsMay 1, 2012 at 4:56 pm

Dave, we are still running a budget deficit and a current account deficit, so we still are consuming beyond our production capabilities, no matter how constrained or misallocated they are. The overhang in housing and diminished labor force reduces potential GDP.

I agree with you on structural unemployment. Resources for durable goods have been idled for decades or pulled forward. The distortions will ripple through time.

The problem with most economic models is their lack of dynamism. Say’s Law and the production identity are two examples. A country can exist with perpetual debt. This does not mean that there aren’t trade offs.

Trade can enhance consumption possibilities beyond the sum of production possibilities.